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All-time highs and Q3 results outlook: Reasons to be fearful or optimistic?

13 October 2017

While the general public struggled with lack of political progress around the world, most western stock markets reached new highs. Fitting that this happened as we passed the 10th anniversary of the pre-GFC (global financial crisis) stock market highs.

On the political side, it was frustrating to observe that the two sides of the Brexit negotiations still appear to be focusing on their differences, rather than trying to establish coming ground in order to move forward. Similarly, in Spain, the Catalonian regional government and the Spanish government in Madrid exchanged tit-for-tat threats, rather than following the explicit wish of their population to engage in talks to find a better solution. For the time being, the Catalans seem to want to avoid having their very own ‘Brexit moment’, and so the optimists will be hoping for de-escalation over the coming weeks. Over in the US, president Trump’s keenness to reverse as much of Obama’s reconciliation deal with Iran – as well as his Affordable Care Act (ACA/Obamacare) – is equally frustrating.

For investors, it is therefore more uplifting to focus on the world of the actual economy, and the companies whose shares we invest in. Against the aforementioned historical and present stock highs, it is worth reflecting on both, and exploring what they tell us about the likely future course.

More cautious investors were keen to focus on the 10th anniversary of the previous market peaks for both the S&P500 and DOW Industrials. Back then, the Dow hit a record high of 14,000 and President George Bush Jr was on TV stating the US had a “vibrant economy”. As we now know, that peak was followed by a fall of more than 50%, as the financial crisis later gripped the world.

As can be seen in the chart to the left, those who invested into a multi-asset portfolio at this historic stock market peak would have found bonds and gold to be the best immediate counterweights to their stock market losses, while, over the years since then, stocks themselves made such a vigorous comeback that they have beaten bond returns, and will soon leave gold behind as well.

Some commentators to last week’s high point and anniversary cited statements from central bankers, like the US Fed’s Williams, cautioning that they “don’t want there to be any excesses in financial markets” as reasons to worry, given the strong market performances over the past few years. Others point to financial ratios like high Price-to-earnings (PE) and Price-to-sales (currently 2.2x) coming within 4% of the March 2000 peak (see chart above).
This may have led to the apparent rise in the S&P500 SKEW Index (a measure of tail risk or potential risk in financial markets), amid expectations of some kind of market pullback.

But are these fears justified?

We believe there are good reasons to be more optimistic, and expect further gains in asset prices. Admittedly, these might be more muted relative to previous stronger years, when central banks’ QE programs provided additional support.

We note that economic activity levels during Q3 have remained robust, with strong forward-looking Purchasing Manager’s Index (PMI) prints and the US ISM (manufacturing) index reaching its highest level since 2004.

Additionally, we had upgrades to global growth expectations from the OECD in September and the International Monetary Fund (IMF) this week. The OECD projects that world GDP will grow 3.5% in 2017 and a quicker 3.7% in 2018. It would seem that the current upturn in momentum has “become more synchronised across countries” as “investment, employment and trade expanded”.

The IMF said that the world economy is enjoying the broadest and fastest rate of growth since 2010, on the back of rising business investment (!), which is improving longer-term economic prospects. The IMF broadly agrees with the OECD’s projections and expects global GDP to expand a stronger 3.76% in 2017 (+0.4pp) and another 3.7% in 2018.

These expected rates of growth are much stronger than those seen earlier this decade, allowing the world to move back to the 30-year longer-term average. Better global growth prospects are supported by continued low inflation across the world and low interest rates. The winding down of fiscal austerity should additionally help boost household incomes.

These are powerful tailwinds for the prospect of improving corporate earnings, which form the ultimate foundation for share valuations and thus sustainable stock market levels. 2017 has so far been a good year for company profits. Q1 in the US delivered double-digit annual earnings growth of 14% and another 11% in Q2, but earnings growth was even stronger in Europe with an annual rise of 25% in Q1 and 14% in Q2.

Compared to these past results, consensus projections for Q3 in the US have more than halved over the past six months, from 9% at the beginning of the quarter to just 2.8% for the S&P500, and 12% to 6% for Europe. Ironically, these reductions actually lower the hurdle rate for companies, and make it easier to deliver positive earnings surprises.

For Europe, in 2018, consensus expectations predict just 8-12% EPS growth. This is the lowest hurdle rate for companies since 1990. It would seem that beating the current consensus might not prove to be that difficult.

At a sector level, financials (banks) should continue to see earnings improvements on the back of rising credit growth and higher bond yields, which helps expand Net Interest Margins (the measure of profits at banks). Additionally, the earnings base itself for the financial sector still looks low relative to history.

The recent rebound in commodity prices during Q3 could likely provide support to the earnings of the Energy and Mining sectors. Some analysts believe that the Energy sector in particular could move higher, given fairly depressed relative share price performances, and with oil moving near the top of the current higher range. Like the US, financials and commodities in Europe appear to be driving a large bulk of EPS growth in 2017. But, growth looks more balanced next year across multiple sectors. Industrials, Staples, IT and Telecoms are all predicted to post double-digit EPS expansion in 2018.

In a historical context, the EPS base of the Eurozone is still some 24% below the peak reached during the last cycle, according to JP Morgan, meaning Europe offers greater upside potential relative to the US. On the downside, a stronger Euro could act as a headwind, especially for exporters.

If the 2018 Eurozone GDP growth forecast of around 2% materialises, then investors could see double-digit full year EPS growth. JP Morgan estimate that across Europe the leverage between real GDP growth and nominal EPS growth rate is 7:1. We think this helps support our positive stance on European equities.

That is not to say we are negative on US equities, particularly given the fact that, on current estimates, analysts appear to be only pricing in around a 60% chance of tax reform, where each 5% cut in taxes equates to an EPS boost of $5 per share. There is the chance that the recent US hurricanes have a negative impact on profits, but, given the scale of earnings downgrades, it seems that this effect has already been priced in to estimates (or more!).

The combination of a stronger, more synchronised global economy (UK notwithstanding) and more stable commodity prices should allow for improved corporate pricing power. Inflation readings appear to have hit an inflection point and are possibly now on an upwards trend. Correspondingly, Eurozone selling price expectations on consumer goods have recently reached new highs. JP Morgan estimate that the spread between output prices and wage costs is trending higher, which has positive implications for both sales and profits growth.

We also note that sales growth in the US is tracking near its 5-year high, and firms are increasingly able to pass those revenues to the bottom line. This is possible through increased productivity from business investment measures, given the continued low cost of capital and scarcity of qualified labour.

Those worried that current elevated levels of economic growth are unsustainable (which would make markets vulnerable to sell offs) should be aware that, historically, from the point at which the ISM index hits a reading of 60, stocks rise 70% of the time in the following three and six months.

Amidst the political frustrations, much investor focus will, over the coming three weeks, be on the Q3 corporate results announcements. While we expect certain sectors and companies to report a hurricane related slump in profits, with the so-much-lower hurdle rate, the inevitable positive earnings surprises could act as a positive catalyst that drives further upward momentum in equities as we head into 2018.